Understanding Behavioral Biases in Investment Decision-Making
May 24, 2021
A lot has happened in the stock market since it hit bottom following the COVID-19 outbreak over a year ago. Among other things, volatility increased throughout the year as investors grappled with shifts in fiscal and monetary policies, and no-commission trading platforms such as Robinhood enticed a new group of retail investors to speculate in the stock market. Indeed, the equity investing process can be complicated during speculative periods of investment mania — and we may be in such a period now. It’s a good time to examine four common behavioral biases for investors.
Overconfidence occurs when a person’s confidence in his or her judgments is greater than the objective accuracy of those judgments, especially when confidence is high. If the stock market rewards a company with a higher stock price despite poor fundamentals, investors may begin to think it is their trading prowess that has led to this positive result as opposed to simply being part of a rising market tide. A successful result reinforces the overconfidence bias and could lead to greater risk taking. When returns are strong, even if they run counter to historical market experience, investors want to be optimistic and overestimate their investment acumen. The end result is that overconfidence causes many investors to be blinded to an investment’s risks, and they end up on the wrong side of the trade as the mania unwinds.
The herding bias is when people follow the actions of the crowd instead of making independent decisions based on their own information. This bias exacerbates panic buying or selling because investors feel they need to take some action if they perceive a majority of investors are trading in that direction. Psychologists have conducted numerous experiments demonstrating that even if the crowd-based investment decision is clearly incorrect, many investors will go along with that crowd decision as opposed to keeping their own ideas.
Confirmation bias manifests in the tendency to search for, interpret, favor and recall information in a way that confirms or supports one’s prior beliefs or values. It is emotionally difficult to consider points of view that are counter to one’s own. Considering only information that makes one feel good simply reinforces the overconfidence bias. Investors have to make a concerted effort to find information that challenges their views and then absorb the dissenting information with an open mind. Unfortunately, because this can be a distressing process, many investors are comfortable (and confident) to blindly follow the crowd.
Anchoring bias causes one to rely too heavily on the first piece of information received about a topic and the tendency to view subsequent information through the lens of this first piece of information. Anchoring is an example of a decision-making heuristic, as described by Daniel Kahneman and Amos Tversky.1 A heuristic is a way to simplify decision-making based on a few variables as opposed to taking time to think carefully about new pieces of information. Decision-making heuristics may be useful in making life-and-death snap judgments, but not so for long-term investment decisions. Making gut decisions is easier and less emotionally taxing than making a more thoughtful decision in which all sides of an issue are considered. The anchoring bias tends to lead to a refusal to revise one’s beliefs when presented with new information. Instead, fresh and conflicting pieces of information can be swatted away by declaring that “it’s different this time,” or that “it isn’t different this time.” Either way, new information is likely to be discounted in favor of the initial viewpoint to which an investor has become anchored. In a period of market speculation, trading manias tend to lead to fast decision-making, which then feeds into overconfidence and often leads to overtrading and less-than-optimal returns.
All four biases are intertwined and often compound one another, potentially leading to unwanted outcomes.
Conclusion: Behavioral biases in today’s market
After years of low interest rates, inflation and little economic growth, it appears these market indicators may be reversing course. Should this hold true, it would likely mean the end of both a 30+ year bull market in fixed income and an extended period of dominance by large-cap, growth-oriented stocks. As often happens during shifts in the investment landscape, many issues that prospered have begun to falter, while many of the shunned assets are rising in value. Behavioral mistakes would tend to lead an investor to stick with the prior winners because those are the assets that brought investment success, and any reconsideration would mean challenging an overconfident assessment of one’s abilities in those gains. Peaks in investment manias tend to lead to greater risk taking due to an overconfidence in investment abilities, herding into a small subset of securities and a lack of consideration of downside risks due to confirmation bias and anchoring. All of these facets are present in today’s financial markets.
We believe the single most important defense against becoming a casualty of the inevitable bust that follows an investment mania is simply to be aware that decision-making bias is present in most people. Awareness can help to mitigate biases, but there is no way to completely eradicate them. Consistent and dispassionate decision-making are the keys to long-term success. As John Maynard Keynes once said, “Markets can remain irrational longer than you can remain solvent.”
1 Tversky, A., & Kahneman, D. (1974). Judgment under uncertainty: Heuristics and biases. Science, 185(4157), 1124-1131.
This is an excerpt from a paper written by Jordan Irving, Portfolio Manager, Small/Mid Cap Equity at Glenmede Investment Management, LP, an affiliate of The Glenmede Trust Company, N.A.. This paper is based on information gathered in good faith, but accuracy is not guaranteed. It reflects the opinions of the author, which are current only as of this date. This presentation is intended to be an unconstrained review of matters of possible interest to Glenmede Trust Company clients and friends and is not intended as personalized investment advice. Advice is provided in light of a client’s applicable circumstances and may differ substantially from this presentation. Opinions or projections herein are based on information available at the time of publication and may change thereafter. Information obtained from third-party sources is assumed to be reliable, but accuracy is not guaranteed. Outcomes (including performance) may differ materially from expectations and projections noted herein due to various risks and uncertainties. Any reference to risk management or risk control does not imply that risk can be eliminated. All investments have risk. Clients are encouraged to discuss the applicability of any matter discussed herein with their Glenmede representative.